Interest Rates and Monetary Policy – Where are we Now?

Living in a world of low interest rates is nothing new. In fact, with interest rates having remained so low over the last few years, and now at historic all-time lows – it’s hard to remember a time of high interest rates.

Over the course of the last eleven years we’ve seen many countries pursue this strategy to help boost economic growth and resilience and we now live in a world where interest rates across most countries are the lowest we have ever seen (in fact in some countries rates are negative!)

In this blog, we take a look at low interest rates within the frame of wider monetary policy.

Monetary policy, or the demand side of economic policy, is action that a country’s central bank or government can take to influence how much money is in the economy and how much it costs to borrow. It is used to promote macroeconomic targets that support sustainable economic growth and it generally involves influencing the money supply through interest rates or open market operations (quantitative easing or QE).

Here in the UK the Bank of England are responsible for monetary policy and their mandate is primarily to maintain the rate of inflation at 2% per annum, thus promoting economic stability. However, the Bank of England do have the powers to use monetary policy to help support wider economic goals, such as employment and economic growth. Indeed, in 2008 the Bank of England pursued one of the most aggressive forms of expansionary monetary stimulus in history by reducing interest rates to 0.50% per annum from 5% per annum. Only recently, we saw them step in to take emergency steps to reduce rates further to 0.10% per annum during the early stages of the Covid-19 epidemic in the UK.

Low or negative interest rates support economic growth in times of stress because they reduce the costs of borrowing for business and for households. This means that they are able to spend and invest, which in turn helps aid economic recovery.

However, there is a limit to how low interest rates can go before the measure becomes less effective or ineffective. For this reason, central banks across the world have pursued aggressive Quantitative Easing programmes alongside the reduction of interest rates. At its simplest, Quantitative Easing involves central banks digitally creating money which is then used to buy government bonds. Large purchases of government bonds help to keep bond yields low, which in turn helps to keep borrowing costs low.

Following the QE packages announced in March and June 2020, the Bank of England’s bond purchases will rise by £300bn to £745bn.

Government Bonds

It is interesting to see how these bond purchases (QE) have acted to support the government’s ability to fund their rescue package.  As many will be aware, the Chancellor of the Exchequer, Rishi Sunak, announced a support package for businesses valued at £350bn. The size of the stimulus speaks for itself. The government doesn’t have this sort of capital in a bank account ready to deploy. Capital therefore must be raised by issuing government bonds; debt-based investments that involve investors, institutions or other governments loaning money to a government in return for an agreed rate of interest (coupon) usually over a defined period of time (term to maturity).

Governments issuing bonds to help fund public spending is nothing new, it happens annually in line with their expenditure plans, and the government is usually able to sell these bonds with relative ease.

However, the rescue package needed to mitigate the impact of Covid-19 has been so large, the size of the stimulus means the government has had to issue a huge amount of debt very quickly at a time when the UK currency is weakening and investors are more risk averse.

The Bank of England’s QE package helped the UK government solve this problem by buying a large proportion of the bonds themselves. By avoiding the potential issue of not having a sufficient amount of buyers prepared to invest in bonds, the risk of higher cost of government borrowing has subsequently been circumvented. Keeping borrowing costs low is important for the long-term economy, leaving the country better placed to support the economy and public services in the future for generations to come.

Other Asset Classes

Quantitative easing and low interest rates also provide indirect support for other assets classes. as the demand for government debt increases, deposit rates fall as do yields. The result being that investors may have to look to riskier areas of the stock market and the economy in their search for income and or return.

In environments where too much money is invested and not enough spent, the flow of money into the real economy can reduce, creating ‘asset bubbles’ rather than support for employment and wages. Rising unemployment and falling wages can result in deflation.

However, low interest rates usually encourage borrowing which adds new money to the money supply. This can cause inflation because there is more money in the system which chases a fixed amount of goods and services, so prices rise. To avoid this central banks must act quickly enough to increase rates and sell bonds back into the secondary market once signs of a recovery support a reversal of monetary expansion.

Debt

It is true that at times of monetary expansion and low interest rates borrowers will see their cost of debt fall. The effects of low interest rates can take some time to feed into the economy but in time households have lower mortgage repayments and therefore higher levels of disposable income and business pay less to finance their operations which can help to improve their return on investment (all things being equal).

However, it’s not all good news for borrowers. Those seeking finance may find it more difficult. This is because when interest rates fall, the banks generally have less capital to lend out as their deposit base falls and lower interest rates reduce the profitability of a loan which doesn’t encourage taking risks and creates a reluctance to lend.

Nobody, as yet, knows the long-term extent of economic damage Covid-19 will have. Due to the unprecedented nature of the virus, it’s difficult to apply models from previous economic downturns and therefore, it’s equally hard to predict how quickly the economy will recover.  The use of monetary policy is clearly complex, with many different variables in play, and it will be interesting to see how policy-makers respond as and when the green shoots of recovery occur.

Notwithstanding this, it’s difficult to see any scenario in which the Bank of England or any Central Bank across the globe start to increase interest rates materially in the short to mid-term. Unfortunately for savers, this means that deposit rates are likely to remain unprecedentedly low for the foreseeable future.

 

NB. The value of investments can fall as well as rise. You might not get back what you invest.

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